Markets & Finance

Natural Selection, Net-Style

March 13, 2003

By Scott Kessler With all the post-mortems of how the dot-com bubble burst three years ago, I thought it would be interesting to ponder what has enabled some Internet companies to survive and thrive, while countless others met their demise. TheStreet.com's Internet Index -- which we at Standard & Poor's consider a good proxy for the Internet industry -- ascended an impressive 57% in 1997 (the index was launched in February that year), 160% in 1998, and 184% in 1999. Then it fell a sobering 74% in 2000, 36% in 2001, and 56% in 2002. In the three years since the Nasdaq peaked in March, 2000, the Internet Index has dropped a staggering 93%.

Understandably, the TheStreet.com Internet Index has experienced significant turnover. Remember Egghead.com, Excite@Home, and Exodus? All were one-time components of the Internet Index that filed for bankruptcy. How about MarchFirst and Open Market? Both of these former index constituents were bought by consolidator Divine, which filed for Chapter 11 just late last month. And "Internet incubators" CMGI and Internet Capital Group, which have been also dropped from the index, accounted for a combined $758.4 million in net losses in 2002, a drastic improvement from their net losses of $7.7 billion in 2001.

In S&P's view, the Internet sector and the way its companies are evaluated have changed dramatically since the late 1990s. The biggest difference is the industry's shift in focus from growth to profits. During the boom time, growth was measured in terms of eyeballs, traffic, users, and revenues. Companies were focused on capitalizing on the so-called first-mover advantage, where first-to-market participants were perceived as likely winners.

FOLLOW THE LEADERS. Back then, startups used capital gladly provided by venture capitalists, investment bankers, and investors to spend heavily on sales and marketing to fuel growth. Because few dot-coms generated earnings, fundamentals and valuations were assessed using revenue metrics.

Internet stocks started their descent in March, 2000, as the companies' financiers and investors became increasingly concerned about the lofty valuations and long-term viability of their holdings. As shareholders clamored for a clear "path to profitability," discretionary spending was slashed, businesses were restructured, and employees were furloughed. A weak global economy and the September 11 terrorist attacks made everything worse.

Ultimately, though, the companies that survived the gauntlet of one of the worst periods in stock market history did so by being financially strong and savvy. These Internet survivors have financed their expansion primarily by generating earnings and using their cash reserves. Many dominate their industries and have used their leadership in core markets and strong balance sheets to expand into ancillary areas and new geographies through internal growth and acquisitions. In the pursuit of optimal asset mixes, these companies have also scaled back businesses that weren't working.

AUCTION POWERHOUSE. eBay (EBAY

, ranked 3 STARS, or hold, by S&P) has only gotten stronger in the last three years. It has taken substantial market share and become much more profitable since then. Despite the drastic sell-off in dot-com stocks, eBay's market capitalization has actually increased slightly since the Nasdaq peaked.

This consistently profitable company dominates the online-auction category, largely as a result of its focus on community (or user feedback). eBay has also benefited from so-called network effects, the phenomenon whereby a service becomes more valuable as more people use it and encourages increasing numbers of users and usage (see BW Online, 2/28/03, "It's Hard to Beat 'Network Effects'").

Through organic growth and acquisitions, eBay has successfully pursued new auction categories, value-added services (such as online payments), pricing formats, and geographies. It has also shown that it will shutter ventures if they don't make financial sense. Last year, eBay closed its Japanese Web site and began the process of selling some of its non-Internet assets such as Butterfields and Kruse International.

PORTAL KING. Yahoo! (YHOO

, ranked 1 STAR, or sell) has been a market-share leader in online content for years. It boasts 213 million users and has 47% market reach. Yahoo has leveraged this position to become a winner in Internet communications, commerce, and services, amassing more than $1.5 billion in cash and investments as of December, 2002.

After being profitable every year from 1998 to 2000, Yahoo lost $92.7 million in 2001 as many corporations reigned in online-advertising spending. That year, Yahoo began to revisit its business model, which historically derived more than three-quarters of its revenues from cyclical marketing services. The company has endeavored to diversify its revenues by pursuing more opportunities predicated on fees and listings. Last year, Yahoo acquired online career-services site HotJobs and launched a joint-venture DSL offering with SBC Communications (SBC).

It has also been more conservative in internally developing new growth areas, such as premium e-mail services and personals (or online-dating), by being mindful of profitability. These concerns also led Yahoo to discontinue its online auctions and in-house broadcast content.

AD MASTER. DoubleClick (DCLK

, ranked 3 STARS) has transformed itself over the past several years. In the mid-1990s, its sole business was selling online advertising on behalf of members of its media networks. Aiming to expand, DoubleClick built complementary technology and data businesses, largely through acquisitions. It derived 68% of its 2001 revenues from the software and services it provided for online, e-mail, and direct marketing.

In 2002, DoubleClick sold its European and North American media operations in two separate transactions. As a result, we expect it to report its first annual operating profit in 2003 since 1995. The company was able to survive and succeed due its strong balance sheet, which resulted from timely capital-raising and smart and conservative expense management. As of December, 2002, DoubleClick had $588 in net cash and investments.

The Internet companies that withstood the dual downdrafts in investor sentiment and service revenues are those that made use of important resources like market leadership, cash reserves, and management acumen. This seems quite logical, but common sense hardly prevailed during the dot-com boom. As some companies were throwing lavish IPO and product-launch parties and outfitting their offices with Aeron chairs and foosball tables, DoubleClick, eBay, and Yahoo were plotting their next moves and financing them with their own money. Analyst Kessler follows Internet stocks for Standard & Poor's